Say It Ain’t So: SEC Charges "Shoeless" Goldman Sachs With Setting Up CDO To Fail

Posted on April 16, 2010 by Isaac Gradman

In a move that represents a significant and unexpected expansion in U.S. regulators’ efforts to crack down on Wall Street, the Securities and Exchange Commission (“SEC”) has charged Goldman Sachs, Wall Street’s most powerful bank, with fraud over its marketing of a subprime mortgage derivative product.  The complaint alleges that Goldman designed and marketed a “synthetic collateralized debt obligation” (“CDO”) known as ABACUS 2007-AC1 in order to give investor Paulson & Co., Inc. the ability to short subprime mortgage bonds, without disclosing to the bank on the other side of the deal of the bond insurer that was acting as the deal manager that Paulson had shorted more than $1 billion of the securities.  Details of the complaint are still emerging, but this Reuters Factbox contains a good summary of the complaint and the details of ABACUS 2007-AC1.

News of the charges sent most equities and commodities into a tailspin, with the exception of the stocks of some mortgage insurers, such as MBIA and AIG (whose bond insurer, United Guaranty, is involved in several suits with lenders, including Countrywide), which saw gains as investors anticipated that the companies would obtain additional fodder for their active lawsuits against banks such as Countrywide/BofA, Citigroup and Credit Suisse.
At around 4:00 PM EDT today, the Goldman Sachs Group issued the following comments response to the SEC complaint, which were posted at theflyonthewall.com:
We are disappointed that the SEC would bring this action related to a single transaction in the face of an extensive record which establishes that the accusations are unfounded in law and fact. We want to emphasize the following four critical points which were missing from the SEC’s complaint. 1) Goldman Sachs Lost Money On The Transaction. Goldman Sachs, itself, lost more than $90M. Our fee was $15M. We were subject to losses and we did not structure a portfolio that was designed to lose money. 2) Extensive Disclosure Was Provided. IKB, a large German Bank and sophisticated CDO market participant and ACA Capital Management, the two investors, were provided extensive information about the underlying mortgage securities. The risk associated with the securities was known to these investors, who were among the most sophisticated mortgage investors in the world. These investors also understood that a synthetic CDO transaction necessarily included both a long and short side. 3) ACA, the Largest Investor, Selected The Portfolio. The portfolio of mortgage backed securities in this investment was selected by an independent and experienced portfolio selection agent after a series of discussions, including with Paulson & Co., which were entirely typical of these types of transactions. ACA had the largest exposure to the transaction, investing $951M. It had an obligation and every incentive to select appropriate securities. 4) Goldman Sachs Never Represented to ACA That Paulson Was Going To Be A Long Investor. The SEC’s complaint accuses the firm of fraud because it didn’t disclose to one party of the transaction who was on the other side of that transaction. As normal business practice, market makers do not disclose the identities of a buyer to a seller and vice versa. Goldman Sachs never represented to ACA that Paulson was going to be a long investor.
Goldman has repeatedly put forth this type of argument in response to mounting criticism about the bank’s conduct leading up to the financial meltdown (see, e.g., Goldman’s response to allegations in an article in the New York Times to the effect that Goldman used inside information to short the same CDOs it had created).  Namely, that Goldman Sachs would not do anything that would cause it to lose money, that Goldman never discloses who it does business with, and that Goldman only deals with sophisticated investors.  But, these defenses will hold little water if evidence emerges that Goldman knowingly set up a process for creating this CDO that allowed a more favored investor on one side of the transaction to tilt the odds in its favor, or if it turned out that Goldman also bet against ABACUS 2007-AC1.  These sorts of facts would recall images of arsonists burning down buildings to collect insurance or the 1919 Black Sox getting paid to throw the World Series.  Otherwise, it may be very difficult indeed to prove fraud, especially against the strong legal team Goldman is certain to retain.

Paulson & Co., Inc., who made waves by posting yearly returns in the 300-600% range in the aftermath of the global financial crisis by shorting subprime and Alt-A mortgage-backed securities, has not been formally charged with any wrongdoing by the SEC.  However, the company also issued a statement regarding the SEC’s Complaint, which was posted on Dealbreaker this afternoon:

As the SEC said at its press conference, Paulson is not the subject of this complaint, made no misrepresentations and is not the subject of any charges.
While Paulson purchased credit protection from Goldman Sachs on securities issued under the ABACUS ABS CDO program, we were not involved in the marketing of any ABACUS products to any third parties.
ACA as collateral manager had sole authority over the selection of all collateral in the CDO, securities of which were subsequently rated AAA by both S&P and Moody’s.
Paulson did not sponsor or initiate Goldman’s ABACUS program, which involved at least 20 transactions other than that described in the SEC’s complaint.
SOURCE Paulson & Co. Inc.

If the writing wasn’t already on the wall, this complaint makes official the shift in U.S. regulatory policy from one of protecting large Wall St. banks to one aimed at holding them accountable.  This should only encourage mortgage insurers and mortgage bond investors to ramp up their efforts to recover losses from lenders through the courts.  We will certainly be following this story as it develops.

Posted in AIG, CDOs, Goldman Sachs, investors, lenders, MBIA, mortgage insurers, Paulson and Co., regulation, SEC, securities, securities fraud, Wall St. | Leave a comment

BlackRock Puts Pressure On Banks To Absorb Losses

Posted on April 8, 2010 by Isaac Gradman

BlackRock, a major asset management firm and one of the largest investors in U.S. mortgage bonds, announced last week that banks would have to absorb the losses on their holdings in second-lien mortgages before it would resume purchasing “private-label” mortgage bonds in any significant quantity.  This represents, to my knowledge, the first instance of an investor threatening to boycott future bond issues as a strategy to solving the gridlock surrounding mortgage-backed securities.

As I’ve discussed in the past, these toxic assets have remained largely illiquid because the players involved cannot agree who should bear losses associated with distressed mortgages.  While loan modifications, short sale programs and other workout plans have been rolled out and encouraged by Washington, banks acting as servicers for the underlying loans have been reluctant to comply due to their large second-lien holdings (that would be wiped out in the event of a modification) and their dependence on the late fees generated by loans in delinquency status.  Such conflicts of interest have thrown a wrench in plans to rescue troubled homeowners, liquidate toxic assets and restart the stalled-out mortgage bond market.

But, now that private investors are beginning to return to the U.S. mortgage market, and there is talk of the issuance of new securitizations, I think investors like BlackRock are making a wise move in leveraging their massive capital (BlackRock manages fixed income investments of over $580 billion) to force banks to write down their second-lien mortgages.  And lest the investor be seen as a bully, let’s not forget that the banks acting as servicers for these loans were often the same institutions whose lending arms irresponsibly created these loans in the first place.  When you throw in the fact that second-lien loans are structured to take the first loss in the event of default, and that these servicers should be working in the best interests of investors to modify loans pursuant to their contracts and their servicing obligations, BlackRock’s position seems imminently reasonable.

[Thank you to Chris Corio for bringing this story to my attention – IMG]

Posted in allocation of loss, BlackRock, conflicts of interest, investors, irresponsible lending, junior liens, loan modifications, MBS, securities, toxic assets | 1 Comment

Federal Home Loan Bank of San Francisco Sues Over RMBS Losses As Investor Actions Build Steam

Posted on March 17, 2010 by Isaac Gradman

One month ago, with the filing by the Federal Home Loan Bank of Seattle of eleven lawsuits against the major Wall Street creators of residential mortgage-backed securities (RMBS), I speculated that the floodgates of investor litigation may finally be swinging open. Yesterday, the filing by the Federal Home Loan Bank of San Francisco (“FHLB of SF”) of two lawsuits seeking the rescission of over $19 billion of purchases of RMBS made it official–the flood is upon us.

The lawsuits (copies posted here and here) were filed in San Francisco Superior Court against a laundry list of the most prominent subprime and Alt-A securitization masterminds, including Deutsche Bank, J.P. Morgan, Bear Stearns, Credit Suisse, Royal Bank of Scotland, Morgan Stanley, UBS and Merrill Lynch. Both actions contain claims for relief based on violations of the California Corporations Code for untrue or misleading statements (CCC sections 24501 and 25501), the Securities Act of 1933 for untrue or misleading statements in registration statements (Section 11) and in the sale of securities (Section 12(a)(2)) and for liability of controlling persons (Section 15), and common law and statutory claims for rescission and negligent misrepresentation. The FHLB of SF is represented by Grais & Ellsworth LLP, a New York litigation boutique, and Goodin, MacBride, a small San Francisco shop. Grais & Ellsworth, which is emerging as a major player in RMBS bondholder litigation, also represents the FHLB of Seattle in the investor action filed last month, as well as Greenwich Financial in its suit against Countrywide (see complaint here, link to attorney David Grais discussing the lawsuit here, and a collection of my prior postings on the lawsuit here).

In a statement issued yesterday, the FHLB of SF confirmed that it was seeking to rescind its purchases of 134 securities in 113 securitization trusts, for which the Bank paid more than $19.1 billion. The statement went on to note that, “[a]ll of the [private-label RMBS] in the Bank’s mortgage portfolio, including those identified in the complaints filed today, were rated AAA when purchased, based on the information provided by the securities dealers. The Bank employs conservative criteria and guidelines for all its MBS investments.”

Though these lawsuits are certainly the largest RMBS investor lawsuits stemming from the financial crisis, they follow on the heels of several similar actions filed since the year began, including an action by the the International Union of Operating Engineers-Employers Construction Industry Retirement Trust against UBS and others in the District Court of New Jersey and an action by Footbridge Limited Trust against Countrywide/BofA and others in the Southern District of New York.

The FHLB of SF complaints read more like educational pieces about investing in asset-backed securities than claims for securities fraud. They are long on explanations about the creation of securitizations, the players involved and the sale of securities, but short on factual allegations about the misrepresentations underlying the bank’s causes of action. The basic allegations as to each claim and each Defendant are that 1) the Defendants made representations in RMBS prospectuses that underlying loans would meet certain quality control standards and underwriting guidelines; 2) these statements turned out to be false because the originators were actually making frequent and unjustified exceptions to these guidelines and failing to follow quality-control practices to detect fraud; and 3) these misrepresentations materially increased the risk of the certificates.

Yet, from my reading, the only facts or evidence that the FHLB of SF has to support its claims is that the loans in the pools that have been foreclosed-upon sold for a fraction of the value ascribed to them, and further, that an analysis of an industry-standard database of securitized loans reveals that the drop in value could not have been caused by the decline in the housing market. (All of these allegations as to particular securitizations are contained in numerous “Schedules” attached to the complaints. I’ve posted a sample of one such Schedule here, which appears representative of the voluminous attachments.)

Were you expecting more? I was. It’s not everyday you see a major institutional investor with tens of billions of dollars under management file a lawsuit against nine
of the largest investment banks in the world on circumstantial evidence. Granted, these complaints were far more streamlined, logical and understandable than the eleven rambling, 80+ page complaints filed by the FHLB of Seattle last month (a sample of one such complaint–against Credit Suisse–is posted here). But, couldn’t the bank have alleged more details about the underwriting of the underlying pool of loans, including the percentage that contained underwriting defects or the instance of borrower fraud found therein? Not if they don’t have the underlying loan files.

What I realized is that one of the biggest battles raging right now behind the scenes between RMBS investors and servicers/lenders is the battle over loan files. Servicers, who often originated these abysmal loans, and who are currently suspected of additional malfeasance in the servicing of these loans (see prior articles here and here), are loathe to turn over loan files that would reveal the depths of their depravity. And securitization trustees, the only players with the authority to obtain loan files and enforce servicer obligations, are incentivized by the structure of most securitizations to be passive and averse to confrontation.

So, the likely answer is that the FHLB of SF and other RMBS investors have been denied the underlying loan files necessary to determine how bad the underwriting and servicing of these loans has really been. With statutes of limitations deadlines likely approaching, they have been forced to file suit before having all the facts and hope that they can gather hard evidence in discovery. If they can’t, plaintiffs like the FHLB of Seattle and SF will have a very hard time overcoming a motion to dismiss, let alone obtaining a verdict in their favor.

Posted in bondholder actions, Complaints, Federal Home Loan Banks, Grais and Ellsworth, incentives, investors, lawsuits, rescission, RMBS, securities, securitization, servicers, Wall St. | 7 Comments

Home Loan Bank Lawsuit May Signal Floodgates Opening For Investor Actions

Posted on February 18, 2010 by Isaac Gradman

As reported this week in the Wall Street Journal (article available here, with subscription), the Federal Home Loan Bank of Seattle has filed separate lawsuits against 11 different Wall Street firms, alleging that it was misled about the quality of over $4 billion in mortgage-backed securities. The lawsuits, filed in King County Superior Court in Washington, seek to force the firms to repurchase these securities, plus interest. The largest of the lawsuits pits the Home Loan Bank of Seattle against Bear Stearns, Co. (now owned by JPMorgan Chase & Co.) and seeks the repurchase of $719 million in securities bought between March 2006 and September 2007, which feature a foreclosure rate of over 25%, according to the suit.

Is this the beginning of the flood of investor lawsuits that we have been anticipating since this crisis began unfolding in 2008? Some commentators think so. Bert Ely, a banking consultant based in Alexandria, VA is quoted in the WSJ article as saying that, “[o]ther similarly-placed investors would take note, both in the U.S. and outside.” Christopher Whalen, managing director for Institutional Risk Analytics said that a ruling against the Wall St. firms would “start a stampede” by other investors.
I have long been predicting that we would see a wave of investor suits, based upon the well-documented decline in underwriting standards from 2006 to 2008, the skyrocketing delinquency rates resulting from this abdication of underwriting and the resulting losses in pools of securitized home mortgages, and the fact that large institutional investors held significant stakes in these pools. But, up to now, such suits have been few and far between.
The WSJ article suggests that this has been because of the time-consuming and expensive audits of loan files that would be required to demonstrate underwriting deficiencies. But, this tells only part of the story. Another reason for the delay is the fact that institutional investors tend to hold the most senior tranches of certificates in securitizations, and these tranches have only just begun to experience losses. This delay in the recognition of losses has been compounded by the Financial Accounting Standards Board’s change in the mark-to-market rule last year that allowed banks to avoid writing down the value of its MBS holdings if it stated that it had the intent and ability to hold onto the assets until their value recovered. Though this rule bought investors additional time to attempt to negotiate with intransigent servicers, investors are beginning to realize that the only way the value of these assets will ever recover is through concerted action or through the courts.
Finally, the political element to this issue cannot be ignored. As discussed previously, the major servicers (generally large Wall Street banks), wield incredible political clout in Washington and have had the ability to alter the regulatory landscape in their favor thus far to avoid the consequences of their irresponsible lending and their self-interested servicing. So long as Washington was catering to servicers and offering the carrot rather than the stick to induce loan modifications, investors hung back, not wanting to appear to be standing in the way of keeping families in their homes. But, now that the political tide has begun to turn against servicers (see articles here and here), investors have become emboldened.
Once investors come to the conclusion that their losses from MBS will not be mitigated through patience or negotiation with securitization trustees and servicers, they will find that their only options are firing those entities, or filing lawsuits. And I am confident that if investors choose to go down the path of investigating the loans underlying their MBS holdings for the purposes of litigation, they will find a mountain of evidence of underwriting deficiencies, and strong legal support for putting these loans back to those who created them in the first place.
[Special thanks to Ken Hausman, Doug Winthrop and Michael Ginsborg for contributing to this article – IMG]
Posted in Bear Stearns, Federal Home Loan Banks, investors, irresponsible lending, lawsuits, litigation, mark-to-market accounting, RMBS, securities, securitization, servicers, underwriting practices, Wall St. | 2 Comments

The Federal Reserve’s Secret Lending of Public Money Is Under Attack

Posted on January 20, 2010 by Isaac Gradman

What follows is an article by Carolyn Austin (contact the author), which was first posted on the Wall St. Cheat Sheet and has been reprinted here with permission. The article discusses an interesting bill being proposed in the House (HR 1207) that calls for a third-party audit of the Fed. I have created a tracker on the right side of this page to follow the progress of this bill, which raises an important debate about whether the Fed should be subject to increased oversight, especially at a time when Congress is also debating giving the private institution more power to regulate banks.
[Editor’s Note: because the original link to Alan Grayson’s views on HR 1207 in Ms. Austin’s article appears to be broken, I have replaced it with a short clip of Grayson speaking about the bill on the floor of the House. Thanks to Damien Hoffman for submitting this article and for posting several articles from The Subprime Shakeout on Wall St. Cheat Sheet.]

*****

Posted on October 14 2009.SHARETHIS.addEntry({ title: “The Federal Reserve’s Secret Lending of Public Money is Under Attack”, url: “http://wallstcheatsheet.com/breaking-news/the-federal-reserves-secret-lending-of-public-money-is-under-attack/?p=2568/” });

Tags: , , , ,

Massive amounts of taxpayer $$$ are flying out the door like monkeys from Oz. Americans simply want to know: Who got our money?

Rather than answer our question, personal enrichment schemes by public officials and bankers dominate the news. Until now Washington has continued the same rhetoric: Let the markets judge while the priests of high finance decide in secrecy.

However, Congressmen Ron Paul and Alan Grayson are leading a popular charge to pass a bill which will mandate a third-party audit of the Federal Reserve. The House is set to vote on H.R. 1207 in the near future — so start paying attention.

Call me crazy, but is it unreasonable to ask, “Why can’t (or won’t) the Federal Reserve account for secret loans equivalent to more than $1 Trillion?” We’re asking for only transparency, not lawmakers dictating interest rates. Isn’t transparent economic activity the hallmark of a democratic society? Let’s hear the experts’ opinions:

Tim Geithner 270

Timothy Geithner doesn’t think the Fed should be transparent:

http://s.wsj.net/media/swf/main.swf

Alan Grayson DR

Congressman Alan Grayson thinks the Fed must be transparent:

Posted in Alan Grayson, Federal Reserve, legislation, oversight, Ron Paul, Timothy Geithner | Leave a comment